What's so bad about adjustable-rate mortgages?

Much-maligned loans may still be worth considering for some borrowers

Adjustable-rate mortgages are currently about as popular as contagious diseases. "I haven't seen a buyer use one since August," said Ted Duncan, an agent with RE/MAX Select Realty in Allston. "The people I am working with are only going fixed rate."

These kind of loans, which adjust interest rates after being fixed for a set period of time, have come in for a pounding because so many of them are behind the foreclosure crisis sweeping the nation. Many borrowers of limited means were able to manage a home purchase based on the lower payments of introductory teaser rates. But as rates on those loans have adjusted upward, the higher monthly payments have been too much for thousands of home buyers.

Though the underlying problem was the borrower's inability to pay, adjustable-rate mortgages got a bad rap in the process.

"At the moment, ARMs are a very disfavored product," said Keith Gumbinger, vice president of HSH Associates, a mortgage research firm.

And it's not just home buyers who are balking. Investors who buy loans and provide capital for the mortgage industry also have lost their appetite for adjustable-rate loans, which at one point made up about one-third of the mortgage market; now they're only about 15 percent.

Yet ARMs may be highly favorable options for certain borrowers today because short-term interest rates are quite low. That makes these loans cheaper than they used to be a few months ago, particularly when compared to fixed-rate mortgages.

Indeed, today's adjustable-rate mortgage is serving a far different market than it was a year or so ago. Gone are the days when lower-income buyers could reach for an ARM to make a home purchase affordable. These days, tighter underwriting standards often requiring a 20 percent down payment have transformed the adjustable loan into a high-end product best suited for people with sterling credit and significant resources. The people who are taking out ARMs today aren't looking for affordability; they're looking for ways to best manage their money.

Currently, there's about a half of a percentage point or more difference between the rate on a conventional, 30-year, fixed-rate mortgage and a 5/1 adjustable loan, which resets after five years and adjusts annually thereafter.

"For the folks who have good credit and are in a stable housing market, there is an advantage there," said Douglas Duncan, who is trading his position as chief economist of the Mortgage Bankers Association in Washington for the same job at mortgage backer Fannie Mae.

Shaving a half-point off a $400,000 loan, for example, can save more than $1,500 a year in borrowing costs. Over the first five years, that's a savings of $7,500 before the initial interest rate on the loan resets.

And those shopping for a jumbo mortgage, which are prevalent in Massachusetts because of high housing costs, will find that the spreads are wider, the savings much bigger. (Jumbo loans traditionally are those that exceed $417,000. But Congress recently authorized a temporary relaxation of limits, raising the limit on jumbo loans in the Boston area to about $524,000.)

Rates on 30-year, fixed-rate, jumbo mortgages have been running at about 7 percent, and even jumped to 8 percent this month when that corner of the mortgage market hit a bump, said Tom McFarland, a fee-only financial adviser with Darrow Co. But a 5/1, adjustable-rate, jumbo loan could be found as low as 5.75 percent, said the Concord-based adviser who often helps clients with their mortgages.

With spreads like that, the savings from a jumbo ARM can run into the tens of thousands of dollars in the five-year period before adjusting.

Going with an adjustable loan is easier for homeowners who are certain they will sell their house before the mortgage resets, whether to move onto another home, to another job outside the region, to downsize, or to retire elsewhere.

If that timetable changes, or if homeowners don't know how long they will stay, there is a risk they will be hit with higher rates when the mortgage eventually resets. Some may feel the savings from the adjustable loan isn't enough to offset the risk that their monthly payments will soar if interest rates rise. That's why only those with the financial wherewithal to cover such increases should be in the ARM market.

One way to protect against the risk of higher payments is to bank the savings during the loan's initial period, Gumbinger said. "Does it require discipline? Sure it does," he said, noting that it's still a relatively painless way to "buy yourself some insurance."

Building in that kind of insurance can be important because rates can be fickle and timing the market is always tricky. For example, folks who took out a 5/1 ARM with a 4.7 percent rate in early 2003 may be surprised to find their reset rate virtually unchanged. "Seven or eight months ago, that borrower would not have fared so well," said Gumbinger, noting that back then, the reset rate would have been around 7.5 percent.

As ever with such volatility, it's wise to shop around. "Some lenders are still aggressively courting buyers," Gumbinger said. For example, borrowers are more likely to find wider variations in rates than they would have a year ago, particularly in the adjustable rate market.

According to the Mortgage Bankers Association, the number of borrowers applying for adjustable mortgages fell to just 8.6 percent in mid-January. At that point, the spread between a 5/1 ARM and a 30-year, fixed-rate mortgage had narrowed to less than 10 basis points, or less than one-10th of a percent. The most recent survey by the association, however, now puts ARM applications at 15.5 percent of the market, reflecting the growing interest created by a widening of the spread between fixed and adjustable mortgages.

So, will the ARM stay in the mortgage doghouse? Investors probably will remember the pain of the current meltdown longer than consumers will, Duncan said. That makes a return to the easy-credit days of recent years unlikely, at least for a while.

The consumer tends to have a shorter memory, he said. "When the general upset in the credit markets slows down and the economy recovers from what now appears to be a recession, they will take whatever product makes the most sense for them."